Chapter 12 Consumption, Real GDP, and the Multiplier

Copyright © 2008 Pearson Addison Wesley. All rights reserved Introduction In recent years, the federal government has reported U.S. households save close to 0% of their income. Is the U.S. rate of saving really that low? How does the share of income that goes to saving matter for the U.S. economy? You will find out in this chapter.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives Distinguish between saving and savings and explain how consumption and saving are related Explain the key determinants of consumption and saving in the Keynesian model Identify the primary determinants of planned investment

Copyright © 2008 Pearson Addison Wesley. All rights reserved Learning Objectives (cont'd) Describe how equilibrium real GDP is established in the Keynesian model Evaluate why autonomous changes in total planned expenditures have a multiplier effect on equilibrium real GDP Understand the relationship between total planned expenditures and the aggregate demand curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline Some Simplifying Assumptions in a Keynesian Model Some Simplifying Assumptions in a Keynesian Model Determinants of Planned Consumption and Planned Saving Determinants of Planned Consumption and Planned Saving Determinants of Investment Determining Equilibrium Real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Chapter Outline (cont'd) Keynesian Equilibrium with Government and the Foreign Sector Added Keynesian Equilibrium with Government and the Foreign Sector Added The Multiplier How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change The Relationship Between Aggregate Demand and the C + I + G + X Curve The Relationship Between Aggregate Demand and the C + I + G + X Curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Did You Know That... In the 1990s some posited new information technologies made recessions obsolete? By 2001, a drop in information technology investment contributed to a recession? Variations in household consumption and business investment affect GDP?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Some Simplifying Assumptions in a Keynesian Model To simplify the income determination model 1. Businesses pay no indirect taxes (sales tax) 2. Businesses distribute all profits to shareholders 3. There is no depreciation 4. The economy is closed; no foreign trade

Copyright © 2008 Pearson Addison Wesley. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Real Disposable Income  Real GDP minus net taxes, or after-tax real income Consumption  Spending on new goods and services out of a household’s current income  Whatever is not consumed is saved.  Consumption includes such things as buying food and going to a concert.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Saving  The act of not consuming all of one’s current income  Whatever is not consumed out of spendable income is, by definition, saved.  Saving is an action measured over time (a flow).  Savings are a stock, an accumulation resulting from the act of saving in the past.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Consumption Goods  Goods bought by households to use up, such as food and movies

Copyright © 2008 Pearson Addison Wesley. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Consumption plus saving equals disposable income. Saving equals disposable income minus consumption.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Investment  Spending by businesses on things such as machines and buildings, which can be used to produce goods and services in the future  The investment part of real GDP is the portion that will be used in the process of producing goods in the future.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Some Simplifying Assumptions in a Keynesian Model (cont'd) Capital Goods  Producer durables; nonconsumable goods that firms use to make other goods

Copyright © 2008 Pearson Addison Wesley. All rights reserved Spending on Human Capital: Investment or Consumption? Economists define human capital as the accumulation of investments and training in education. From this perspective, educational expenses should be regarded as a form of investment spending. Nevertheless, in official U.S. government statistics, household spending on education is classified as consumption.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving In the classical model, the supply of saving was determined by the rate of interest.  The higher the rate, the more people wanted to save, the less they wanted to consume.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving (cont'd) Keynes argued that real saving and consumption decisions depend primarily on a household’s real disposable income.

Copyright © 2008 Pearson Addison Wesley. All rights reserved AD = C + I + G + X Determinants of Planned Consumption and Planned Saving (cont'd) Keynes was concerned with changes in AD

Copyright © 2008 Pearson Addison Wesley. All rights reserved Consumption Function  The relationship between amount consumed and disposable income  A consumption function tells us how much people plan to consume at various levels of disposable income. Determinants of Planned Consumption and Planned Saving (cont'd)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving (cont'd) Dissaving  Negative saving; a situation in which spending exceeds income  Dissaving can occur when a household is able to borrow or use up existing assets.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 12-1 Real Consumption and Saving Schedules: A Hypothetical Case

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving (cont'd) 45-Degree Reference Line  The line along which planned real expenditures equal real GDP per year

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-1 The Consumption and Saving Functions

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-1 The Consumption and Saving Functions (cont'd)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-1 The Consumption and Saving Functions (cont'd)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving (cont'd) Autonomous Consumption  The part of consumption that is independent of the level of disposable income  Changes in autonomous consumption shift the consumption function.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Average Propensity to Consume (APC)  Real consumption divided by real disposable income  The proportion of total disposable income that is consumed Determinants of Planned Consumption and Planned Saving (cont'd) APC = Real consumption Real disposable income

Copyright © 2008 Pearson Addison Wesley. All rights reserved Average Propensity to Save (APS)  Real saving divided by real disposable income (DI)  Saved proportion of real DI Determinants of Planned Consumption and Planned Saving (cont'd) APS = Real saving Real disposable income

Copyright © 2008 Pearson Addison Wesley. All rights reserved MPC = Change in real consumption Change in real disposable income Determinants of Planned Consumption and Planned Saving (cont'd) Marginal Propensity to Consume (MPC)  The ratio of the change in real consumption to the change in real disposable income

Copyright © 2008 Pearson Addison Wesley. All rights reserved MPS = Change in real saving Change in real disposable income Determinants of Planned Consumption and Planned Saving (cont'd) Marginal Propensity to Save (MPS)  The ratio of the change in saving to the change in disposable income

Copyright © 2008 Pearson Addison Wesley. All rights reserved APC = $49,200 $54,000 =.911 Determinants of Planned Consumption and Planned Saving (cont'd) Example  Income = $54,000  C = $49,200  S = $4,800 What is the APC?

Copyright © 2008 Pearson Addison Wesley. All rights reserved APC = $54,000 $60,000 =.90 Determinants of Planned Consumption and Planned Saving (cont'd) Example  Income increases by $6,000 to $60,000  C = $54,000  S = $6,000 What is the APC?

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving (cont'd) Some relationships  Average propensity to consume and average propensity to save must sum to 100% of total income.  Marginal propensity to consume and marginal propensity to save must sum to 100% of the change in income.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving (cont'd) Causes of shifts in the consumption function  A change besides real disposable income will cause the consumption function to shift.  Non-income determinants of consumption  Population  Wealth

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Planned Consumption and Planned Saving (cont'd) Wealth  The stock of assets owned by a person, household, firm or nation  For a household, wealth can consist of a house, cars, personal belongings, stocks, bonds, bank accounts, and cash.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determinants of Investment Investment, you will remember, consists of expenditures on new buildings and equipment.  Gross private domestic investment has been volatile.  Consider the planned investment function, and shifts in the function.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-2 Planned Real Investment, Panel (a)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-2 Planned Real Investment, Panel (b)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Example: Information-Technology Investment Continues to Lag Business spending on IT accounts for about 40% of U.S. investment expenditures. Sometimes IT investment slows down due to businesses cutting back on new IT. Some examples  Reconfiguring existing servers (Vanguard Group)  Firms using open-source software (Linux)

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determining Equilibrium Real GDP We are interested in determining the equilibrium level of real GDP per year  Consumption as a function of real GDP  The 45-degree reference line

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-3 Consumption as a Function of Real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determining Equilibrium Real GDP (cont'd) Adding the investment function AD = C + I + G + X

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-4 Combining Consumption and Investment

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determining Equilibrium Real GDP (cont'd) Saving and investment: planned versus actual  Only at equilibrium real GDP will planned saving equal actual saving.  Planned investment equals actual investment.  Hence planned saving is equal to planned investment.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-5 Planned and Actual Rates of Saving and Investment

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determining Equilibrium Real GDP (cont'd) Unplanned increases in business inventories  Consumers purchase fewer goods and services than anticipated  This leaves firms with unsold products

Copyright © 2008 Pearson Addison Wesley. All rights reserved Determining Equilibrium Real GDP (cont'd) Unplanned decreases in business inventories  Business will increase production of goods and services and increase employment

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Equilibrium with Government and the Foreign Sector Added To this point we have ignored the role of government in our model. We also left out the foreign sector of the economy in our model. Let’s think about what happens when we add these elements.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) Government (G): C + I + G  Federal, state, and local  Does not include transfer payments  Is autonomous  Lump-sum taxes = G Lump-Sum Tax  A tax that does not depend on income or the circumstances of the taxpayer

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) The Foreign Sector: C + I + G + X  Net exports (X) equals exports minus imports  Depends on international economic conditions  Autonomous—independent of real national income

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 12-2 The Determination of Equilibrium Real GDP with Government and Net Exports Added

Copyright © 2008 Pearson Addison Wesley. All rights reserved Keynesian Equilibrium with Government and the Foreign Sector Added (cont'd) Determining the equilibrium level of GDP per year  We are now in a position to determine the equilibrium level of real GDP per year.  Remember that equilibrium always occurs when total planned real expenditures equal real GDP.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-6 The Equilibrium Level of Real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Equilibrium Level of Real GDP Observations  If C + I + G + X = Y  Equilibrium GDP  If C + I + G + X > Y  Unplanned drop in inventories  Businesses increase output  Y returns to equilibrium  If C + I + G + X < Y  Unplanned rise in inventories  Businesses cut output  Y returns to equilibrium

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Multiplier Multiplier  The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures  The number by which a change in autonomous real investment or autonomous real consumption is multiplied to get the change in equilibrium real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Multiplier (cont'd) Question  How can a $100 billion increase in investment generate a $500 billion increase in equilibrium real GDP? Answer  The multiplier process.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Table 12-3 The Multiplier Process

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Multiplier (cont'd) The multiplier formula Multiplier = MPC = 1 MPS

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Multiplier (cont'd) By taking a few numerical examples, you can demonstrate to yourself an important property of the multiplier.  The smaller the MPS, the larger the multiplier.  The larger the MPC, the larger the multiplier.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Multiplier (cont'd) Examples MPC = 3 4 MPS = 1 4 Mult. = 1 1/4 = 4 MPC = 4 5 MPS = 1 5 Mult. = 1 1/5 = 5 MPC = 2 3 MPS = 1 3 Mult. = 1 1/3 = 3 MPC = 7 9 MPS = 2 9 Mult. = 1 2/9 = 4.5 MPC = 3 5 MPS = 2 5 Mult. = 1 2/5 = 2.5

Copyright © 2008 Pearson Addison Wesley. All rights reserved Change in equilibrium real GDP = Multiplier x Change in autonomous spending The Multiplier (cont'd) Measuring the change in equilibrium income from a change in autonomous spending

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Multiplier (cont'd) Significance of the multiplier  It is possible that a relatively small change in consumption or investment can trigger a much larger change in real GDP.

Copyright © 2008 Pearson Addison Wesley. All rights reserved How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change So far our examination of how changes in real autonomous spending affects equilibrium real GDP has considered a situation in which the price level remains unchanged. Our equilibrium analysis has only considered how AD shifts in response to investment, government spending, net exports.

Copyright © 2008 Pearson Addison Wesley. All rights reserved How a Change in Real Autonomous Spending Affects Real GDP When the Price Level Can Change (cont'd) When we take into account the aggregate supply curve, we must also consider responses of the equilibrium price level to a multiplier-induced change in AD.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-7 Effect of a Rise in Autonomous Spending on Equilibrium Real GDP

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Aggregate Demand and the C + I + G + X Curve There is clearly a relationship; aggregate demand consists of consumption, investment, government, and the foreign sector.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd) There is a major difference  C + I + G + X curve drawn with price level constant  AD curve drawn with the price level changing

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd) To derive the aggregate demand curve from the C + I + G + X curve, we must now allow the price level to change.

Copyright © 2008 Pearson Addison Wesley. All rights reserved The Relationship Between Aggregate Demand and the C + I + G + X Curve (cont'd) What are some of the effects of a price level increase?  Real balance effect  Interest rate effect  The open economy effect

Copyright © 2008 Pearson Addison Wesley. All rights reserved Figure 12-8 The Relationship Between AD and the C + I + G + X Curve

Copyright © 2008 Pearson Addison Wesley. All rights reserved Issues and Applications: Is the U.S. Propensity to Save Really as Low as 0.01? Measures of U.S. saving have indicated a big drop-off in personal saving during the past 20 years. Some economists question whether the saving rate really has fallen as much as official figures indicate. “Are disposable income and saving correctly measured?” these economists ask.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives The difference between saving and savings and the relationship between saving and consumption  Saving is a flow over time while savings is a stock.  Consumption plus saving equals disposable income.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Key determinants of consumption and saving in the Keynesian model  In the classical model, the interest rate is the fundamental determinant of saving.  In the Keynesian model, the primary determinant is disposable income.  DI increases, so does C

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The primary determinants of planned investment  The interest rate, business expectations, productive technology, and business taxes

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) How equilibrium real GDP is established in the Keynesian model  Equilibrium national income occurs where the C + I + G + X schedule crosses the 45- degree line.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) Why autonomous changes in total planned expenditures have a multiplier effect on equilibrium real GDP  As consumption increases, so does real GDP, which induces further consumption spending.  The ultimate expansion of real GDP is equal to the multiplier times the increase in autonomous expenditures.

Copyright © 2008 Pearson Addison Wesley. All rights reserved Summary Discussion of Learning Objectives (cont'd) The relationship between total planned expenditures and the aggregate demand curve  AD consists of consumption, investment, and government purchases, plus the foreign sector.  Difference  C + I + G + X curve drawn with price level constant  AD with the price level changing

End of Chapter 12 Consumption, Real GDP, and the Multiplier